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Thursday, 19 June 2014

Scotland's Currency 4: The Way Ahead

In Part 1, Part 2, and Part 3 I have looked at the SNP's plan for monetary union with the rest of the UK (rUK); its rejection by the other UK political parties; and the political consequences for the referendum vote.

Looking at the bigger picture, what currency options does an independent Scotland have? What are their strengths and weaknesses?

Robert the Bruce had no idea it would come to this.

First, a health warning: I have no formal training or professional experience in economics, international law, or foreign exchange markets. The following is based on research I did for the previous posts, and more general background reading. Anyone who wants an in-depth understanding of this material should go to more authoritative sources, some of which are linked below.

That said, I found this material interesting and often it is not well presented in the media. These are the options as I understand them:

Sterling Area: Full currency union between Scotland and rUK.

Sterlingization: Adopt the rUK pound sterling as the currency of Scotland, without a formal currency union.

Pound Scots (pegged): Scotland has its own currency, but constrained to a fixed exchange rate with one or more other currencies.

Pound Scots (floating): Scotland has its own currency, which is allowed to find its own value on the international markets.

The Euro: Scotland joins the 18 existing members of the eurozone.

Let us consider them in greater detail.

1. Sterling Area

In a much smaller version of the eurozone,Scotland and rUK share control of a central bank, which issues currency and acts as lender of last resort for both nations. The requirements for implementation of a Sterling Area are discussed in Part 1. As I detailed in Part 2, it is highly doubtful that rUK will agree to this plan, so it is largely a dead letter.

To be clear, a Sterling Area is possible. The SNP has published opinions from a number of prominent economists to this effect. No less an authority than the Governor of the Bank of England has confirmed it would be technically feasible, if Scotland (and, to a lesser extent, rUK) accept restrictions on fiscal policy. The objections raised by the unionist parties are primarily political, not technical; but they are real objections nonetheless.

2. Sterlingization

An independent Scotland could use the rUK pound sterling as its only currency, without a formal currency union.

Countries including Panama and Ecuador use the US dollar in this way, a system known as dollarization. A similar approach is taken by Jersey, Guernsey, and the Isle of Man. These tax-haven islands are technically not part of the UK, but they use the pound sterling as their currency, with their own banknotes circulating alongside Bank of England notes.

This would preserve a fixed exchange rate between Scotland and rUK, and eliminate some or all transaction costs.

The disadvantages would be significant: Scotland would have no control over interest rates, no lender of last resort to back up its financial system, and no ability to issue currency of its own. In a financial emergency, it would be unable to simply create money to meet its needs, as in the Bank of England's programme of quantitative easing begun in 2009.

3. Pound Scots (pegged)

The value of the pound Scots (S£) would be tied to that of one or more other currencies. The exchange rate might be fixed; or the value of S£ might be allowed to fluctuate within a narrow range, as with the Danish krone and the euro. Most likely it would simply be tied to the rUK pound, but it could also be pegged to a combination of the pound and Euro.

Gavin McCrone, formerly chief economist at the Scotland Office, has suggested this might be the best choice for an independent Scotland. However, the need to maintain a fixed exchange rate would constrain the fiscal policy of the Scottish government.

4. Pound Scots (floating)

In this case, the S£ is allowed to find its own value on the foreign exchange markets. This would give the Scottish government the greatest possible freedom in choosing taxation, spending and interest rates; but it would also give greater exposure to fluctuation in value. The exchange rate across the border with England would change from one day to the next. The uncertainty would create a significant barrier to trade with rUK and further afield.

Norway and Switzerland are small European countries which prosper with floating currencies, but they have advantages Scotland does not; respectively an enormous sovereign wealth fund, and a banking sector unique in the world for its wealth and stability. Maintaining a freely floating currency would be a challenge for an independent Scotland.

5. The Euro

The euro is fairly stable in value and would ease trade with other EU countries; but given the obvious problems of the eurozone, it would likely be unpopular in Scotland. A great deal would depend on the exchange rate at which Scotland entered. Although Ireland has suffered grievous problems in recent years, other small countries such as the Netherlands and Finland have done well enough with euro membership.

A commitment to joining the euro could be a requirement for Scotland to join the EU. The EU treaties make specific exceptions for the UK and Denmark, but all other new members are required to move towards joining the euro. Whether Scotland would inherit the UK opt-out from the euro is a matter of some debate. Ultimately it might have to be settled by the European Court of Justice.

However, even if Scotland does not receive an official opt-out from the euro, EU membership does not necessarily impose a timetable for joining. Sweden is theoretically committed to joining the Euro, but has no immediate plans to do so.

Creation of a Currency

Moving to a new Scottish currency, either as a permanent measure or a precursor to euro membership, would impose significant costs on Scotland. Salaries, bank accounts, government taxation and spending, all would have to be converted to the new currency. Of course, Scotland already has a tradition of printing its own banknotes, but it would also have to start producing its own coins.

Perhaps more importantly, Scotland would have to be concerned about capital flight, if investors and bank depositors felt the need to safeguard their assets by moving them to other currencies; and about the effects of financial speculation.

Security and Freedom

This is one instance where there really is a tradeoff between security and freedom. As part of a monetary union, either a Sterling Area or the eurozone, Scotland would be protected from movements in the exchange rate; but it would give up the power to set interest rates, and some control of taxation and spending. With its own currency, it would have greater freedom of policy, but at the cost of exposure to speculation and changes in the exchange rate.

The third option above, a Scottish pound pegged to sterling, may seem like an attractive compromise; but this also could go wrong. A good illustration is the UK membership of the ERM (exchange rate mechanism) from 1990-92. This was essentially an attempt to peg the pound sterling to other European currencies, including the deutschmark.

In an attempt to maintain the value of sterling, the UK kept interest rates high, which exacerbated a recession. On Black Wednesday, September 15, 1992, the UK raised interest rates twice and spent 300 million pounds of foreign currency reserves, but was ejected from the ERM anyway as the pound fell below the minimum permitted value. The political and economic credibility of John Major's Conservative government never recovered.

All choices have their risks, and it is impossible to predict what events would affect the currency of an independent Scotland.

Conclusion

There are at least five viable options for the currency of an independent Scotland. So far, the SNP has only been willing to discuss one of them. They insist any choice other than a Sterling Area is irrational and immoral.

The SNP are free to believe this, but theirs is not the only opinion that matters. The government of rUK would have the right to refuse a currency union with an independent Scotland. All three main UK political parties have clearly committed themselves to doing so. At 0.04% of GDP, the costs to rUK would certainly be bearable. To put this in perspective, the median household income in the UK is £23,200, and 0.04% of that is less than £10 per year.

It is very possible that the UK parties mean what they say. It would be prudent for Scotland to take them seriously. I have no doubt that the SNP leadership understand this, and have privately discussed the alternatives if a monetary union is refused.

The choice of currency is of vital importance for Scotland. Independence would bring uncertainty and hard decisions on this topic, and it deserves an open and realistic debate. The SNP has done its best to shut down any such debate, by pretending the difficult choices do not exist. This tactic may help to boost the Yes vote in the referendum, but from a wider perspective it does not serve the people of Scotland well.